Let’s take a look at how Roth IRAs and 401(k) plans stack up against one another, and where each is the superior plan.
|Contributions limits||$6,000, plus a $1,000 “catch-up contribution” if you’re 50 or older. Total, $7,000.||$19,000, plus a $6,000 catch up contribution if you’re 50 or older. Total, $25,000.|
|Income limits for contribution eligibility||Married filing jointly up to an income of $193,000; Single, head of household, or married filing separately allowed up to an income of $122,000.||No income limits for most situations.|
|Tax deductibility of contributions||Not tax-deductible.||Tax-deductible.|
|Employer matching contributions||None available.||An employer may match between 50 percent and 100 percent of the employee’s contribution.|
|Tax treatment in retirement||Distributions can be withdrawn tax-free.||Both your contributions and investment earnings are only tax-deferred. You pay income tax when you withdraw.|
|Early withdrawals||Contributions can be withdrawn at any time, tax-free and penalty free. Investment income earned subject to income tax and the 10 percent early withdrawal penalty if taken before age 59 ½.||10 percent penalty.|
|Loan provision||None.||Can borrow up to 50 percent of the vested value of your plan, up to a maximum of $50,000. Repayment must typically be accomplished within five years.|
|Investment options||Self-directed.||Restricted to the investment selected by your employer.|
|Required Minimum Distributions (RMDs)
||Not subject to RMD’s||Fully subject to RMD’s|
Roth IRA – The maximum contribution to a Roth IRA is $5,500, plus a $1,000 “catch-up contribution” if you’re 50 or older. Total, $6,500.
401(k) – The maximum employee contribution for a 401(k) is $18,500, plus a $6,000 catch up contribution if you’re 50 or older. Total, $24,500.
Winner: The 401(k) plan is clearly the favorite here.
There are income limits beyond which you cannot make a contribution to a Roth IRA plan at all.
Roth IRA – For 2018, the Roth IRA income limits look like this:
- Married filing jointly, or qualifying widow(er)—allowed up to an income of $189,000, partial allowed between $189,000 and $199,000, after which no contribution is allowed.
- Married filing separately—partial contribution on an income up to $10,000, after which no contribution is allowed.
- Single, head of household, or married filing separately AND you did not live with your spouse at any time during the year—allowed up to an income of $120,000, partial allowed between $120,000 and $135,000, after which no contribution is allowed.
401(k) – For most participants, 401(k) plans have no income limits. However, there is one exception, for what are known as Highly Compensated Employees (HCEs). Employees determined to be HCEs have very limited plan contributions. However, they can still receive an unrestricted employee matching contribution.
Under IRS rules, a person is determined to be an HCE if they receive income in excess of $120,000, and are in the top 20 percent of employees ranked by compensation within the company.
This is an oversimplified explanation of HCEs, but it is an income limitation that applies to 401(k) plans. It’s one most participants are unaware of—unless they qualify as an HCE.
Winner: Most 401(k) plan participants are not subject to the HCE income limit, so the 401(k) wins on this issue as well.
401(k) – This one’s pretty simple. Employee contributions to a 401(k) plan are generally tax-deductible. And $18,500 (or $24,500) is a big tax deduction for most tax payers.
Roth IRA – Contributions to a Roth IRA account are not tax deductible.
Winner: 401(k), easily.
401(k) – Many employers offer matching contributions in their 401(k) plans. For example, an employer may match between 50 percent and 100 percent of the employee’s contribution.
So if the employee contributes 10 percent of her pay to the plan, and the company does a 50 percent match, they will add five percent of her pay to the plan. That will mean a total contribution of 15 percent per year.
Roth IRA – Since a Roth IRA is a private plan held by an individual, there is no matching contribution available.
Winner: The 401(k) again.
This is where the pendulum begins to swing in favor of the Roth IRA. In fact, it’s the primary attraction of the Roth IRA.
Roth IRA – Distributions taken from a Roth IRA after you turn 59½, and have been in the plan for a minimum of five years, can be withdrawn tax-free. That means no tax either on your contributions to the plan, or the investment earnings that have accumulated over the years.
401(k) – Though it’s possible to have after-tax contributions to 401(k) plan, most are pretax (which is where the tax deduction on contributions comes into play). Both your contributions and investment earnings are only tax-deferred. That means while you escape tax consequences in the build-up phase, you will begin paying ordinary income tax on your withdrawals once you begin taking them in retirement.
Winner: The Roth IRA, and it’s not even close.
401(k) – Typically, if you make withdrawals from a 401(k) plan before you turn 59½, you will not only have to pay ordinary income tax on the amount withdrawn, but also a 10 percent penalty (though there are exceptions).
Roth IRA – The situation is mostly different with Roth IRAs. Since contributions are not tax-deductible, they can be withdrawn at any time, tax-free and penalty free. The investment income earned on those contributions will be subject to ordinary income tax and the 10 percent early withdrawal penalty if taken before age 59 ½.
But the IRS has Roth IRA ordering rules. Those rules hold that the first money withdrawn from a Roth IRA is always contributions, and therefore not subject to tax or penalty.
For example, let’s say you have $30,000 in a Roth IRA plan. $20,000 represent contributions, and $10,000 is investment income earned on those contributions. You can withdraw up to $20,000 from the plan tax-free and penalty-free, since those represent the amount of your contributions.
Winner: Roth IRA.
401(k) – 401(k) plans commonly come with loan provisions. Under IRS rules, you can borrow up to 50 percent of the vested value of your plan, up to a maximum of $50,000. Repayment must typically be accomplished within five years. There are no tax consequences for a 401(k) loan, unless you leave your employer and there is still an outstanding balance remaining.
Roth IRA – Once again, since a Roth IRA is an individual plan, there is no loan provision.
401(k) – When you participate in a 401(k) plan, you’re generally restricted to the investment trustee selected by your employer. If your employer decides that will be a single mutual fund family, you’ll have to work with it.
Roth IRA – But Roth IRAs—just like traditional IRAs—are self-directed accounts. You can choose the trustee for the account, whether it’s an investment brokerage, a mutual fund family, or a robo-advisor. You can also choose whatever investments you want. This can be stocks, bonds, mutual funds, exchange traded funds, real estate investment trusts, options, and even gold.
Winner: Roth IRA.
The IRS has established required minimum distribution (RMD) rules primarily for the purpose of forcing money out of retirement plans, so that it will become taxable. RMD rules hold that retirement plans must begin making distributions to participants beginning no later than age 70½. Typically, the amount distributed is based on your remaining life expectancy.
401(k) – 401(k) plans, like most other retirement plans, are fully subject to RMD’s.
Roth IRA – Roth IRAs are not. You can literally continue to accumulate money in a Roth IRA until the day you die. This makes them excellent plans if your main intention is to leave money to your heirs.
Winner: Roth IRA.
Which should you choose, the Roth IRA or the 401(k)?
We’ll make it easy for you: You should choose both!
Both the Roth IRA and 401(k) are superb retirement plans. The 401(k) has the advantage of enabling you to accumulate a very large amount of money in the plan, particularly if you have an employer matching contribution. It also provides a major tax deduction, and often comes with a loan provision.
But the Roth IRA has the advantage of being tax-free in retirement. That can be important if you have multiple sources of income in your retirement years. By receiving at least some of your income from a Roth IRA, you’ll minimize the tax liability. In addition, the Roth IRA also allows you unlimited investment options, as well as the ability to make tax-free/penalty-free early withdrawals. And the fact that they’re not subject to RMD’s greatly reduces the chance you’ll outlive your money.
The best strategy, if you’re in a position to take advantage of it, is to have both a 401(k) and Roth IRA. It might mean reducing your 401(k) contribution to make room for a maximum Roth IRA contribution. But it will be well worth the juggling act.
Some employers are offering a Roth 401(k) option with the traditional 401(k) plan. If yours doesn’t, you should plan to have an individual Roth IRA, along with your employer sponsored 401(k) plan.
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